The due diligence dilemma with early stage companies
Research by the American Capital Association (2007) and the Kauffman foundation (2007) have provided evidence that seed in preceding investors perform better when adequate diligences done prior to making an investment.
While this may sound trivial and obvious it is surprising how many investors believe they can simply trust their “gut”. Our experience at BlueWater Angels suggests that 60 to 100 hours of diligence is necessary to properly vet most investments. For the club we have learned that this time is best distributed across a group of investors allowing different expertise to be used for different issues. While we have focused on driving our deals with a “deal lead” it is not intended that this individual assume complete responsibility for all elements of the diligence. In fact, a third to a half of the total hours are usually work performed by the club’s executive director and staff. This includes the tedious chore of compiling the raw information including contracts and corporate records.
Good diligence however, is not simply brute force. Regardless of the amount of hours put into the diligence process, it won’t help if the right questions are not asked and addressed adequately. In the most basic sense, good diligence is applied risk management. While a great deal has been written about risk management and risk mitigation, the ability to apply this literature to pre-revenue is not clear. Due diligence implies that an appropriate level of diligence is performed, however it is not clear as to what the appropriate level is nor is it clear as to how efficiently the information is gathered. Given the real time and resource costs associated with diligence for the club the efficiency is vital.Good diligence is often coming to a “no” decision quickly and efficiently while taking an appropriate amount of energy to validate the “yes”. Indeed, the expertise to find a fatal flaw in two hours rather than 200 is a vital skill.
The measure of successful diligence is its ability to guide the investments. The most important issue is to settle on a valuation for the company (usually pre-money as stated on the term sheet). The differences which arise over the valuation, are rooted in divergent beliefs of the facts and the critical assumptions. These facts and assumptions are embedded in the financials and projections, the business plan and the general vision of the founders. Good diligence brings about consensus on these values or alternatively gives clarity to the differences between investor and founder. Illuminating these differences can allow us to put performance milestones in the investment terms that address the specific assumptions we do not agree on. For example the time to complete a proof of concept or prototype product may vary by months or even years and certainly hundreds of thousands of dollars. Knowing that we differ on this issue allows us to offer a lower price for the company but an opportunity for founders to earn back valuation based on meeting a milestone specific to this issue.
In evaluating the financials of an early-stage company the lack of historical data introduces subjectivity to all aspects of the analysis. The spreadsheet is what we put into it and little more. Extensive analysis of existing companies with historical financial data provides a solid foundation for most private equity transactions. In the case of seed and pre-seed investing, these models can identify issues of concern but provide little or no guidance.
An efficient capital market for financing early stage tech companies will require far more effective/efficient diligence methods. Current practices relying on volunteers, a slow processing system and analysis that is not standardized across investor groups, is not adequate to meet our needs.